RITM Goes Multi Asset; TCBI Shrinks Assets, Grows Returns

August 4, 2023 | Premium Service | Several readers asked about the results for Rithm Capital (RITM), one of the more aggressive hybrid REITs in the world of mortgage finance, both residential and commercial. CEO Mike Nierenberg just delivered a record quarter, surprising a lot of analysts. RITM's NewRez taxable appendage is the fourth largest mortgage servicer with over half a billion in loans serviced

RITM’s upside earnings surprise illustrates how difficult it is for even sophisticated investors and analysts to parse the public disclosure of earnings from mortgage companies. Even as RITM works to redefine its business purpose as a manager of alternative assets, it is preparing to spin-off virtually its entire residential mortgage business. But will that interesting possibility ever be a reality? See below.

“Rithm had one of its best quarters ever,” said Nierenberg with considerable pride. “We had near record earnings, grew book value, acquired $1.4 billion of consumer loans and grew our SFR business with the acquisition of 371 units... With the introduction of new capital rules being instituted on banks and the highest level of rates seen in 20+ years, the investing environment has not been this good in years.”

Nierenberg is absolutely right that the Fed has turned over the proverbial card table, to use a Bear, Stearns metaphor. The range of assets being abandoned by banks and other investors as interest rates rise is impressive and mounting. The change in the RITM business is dramatic as illustrated by the table below from the Q2 2023 earnings release.

In Q2 2023, RITM reported net income of $387 million vs $89 million in Q1 2023. What changed? First there was a $160 million swing in realized gains in Q2 vs a loss in Q1. Then RITM took a $45 million gain on its mortgage servicing rights (MSR) and added $82 million more to “income” from MSR related investments. This took net servicing revenue up to $487 million vs $328 million in Q1. Who says mortgage banking is unprofitable?

While RITM only took a small $22 million gain on the value of the MSR to income, it added $161 million in non-cash to servicing income for “change in valuation inputs and assumptions.” This offset the amortization of the MSR of $139 million in Q2 2023. Of note, the MSR realization and the offset for changes in modeled income and assumptions for RITM were exactly the same in Q1 and Q2 2023. We asked RITM if this remarkable coincidence was an error but received no response.

What is interesting about the sharp increase in servicing income for RITM is that the unpaid principal balance (UPB) of loans barely changed in the first couple of quarters of 2023, illustrating how difficult it is for investors to anticipate changes in net income related to servicing. Indeed, RITM's servicing fee revenue, net and interest income from MSR financing receivables, and UPB of servicing, were actually down slightly in Q2 2023.

The big question for RITM shareholders is the timing of a spinoff of the NewRez mortgage business, which is roughly two-thirds of the current assets. In a falling interest rate environment, a spinoff for the mortgage business could create significant value for RITM shareholders. But at the same time, the size of the highly leveraged MSR portfolio and the toppy valuations for these assets could create significant downside risk if rates fall rapidly.

As one of the most respected operators in mortgage finance told The IRA: “In this market, Michael will have a tough time spinning off NewRez, but someone will buy it at a price he will be happy to take.”

RITM is currently dependent upon Goldman Sachs (GS) for warehouse and MSR financing, not an ideal pairing in our book. GS has no comparative advantage in funding for a mortgage warehouse business. The fact that RITM has been buying consumer loans from GS suggests a less than arm's length relationship. We expect to see several smaller bank warehouse lenders exit the mortgage space as volumes remain low and purchase mortgage business predominates.

Texas Capital Bancshares

TCBI had a very good Q2 2023 earnings report, with interest income up 65% YOY and interest expense up a mere 360%. Yet the bank doubled net income since last year and has been shrinking both its balance sheet and its shares outstanding in a very disciplined and prudent fashion. The table below shows the income statement from the Q2 2023 TCBI earnings release.

Total assets are down 10% YOY and the bank’s mortgage finance portfolio is down 20%. Net interest margin has risen to 3.3% and asset returns have doubled since last year, but are still under 1%. Non-interest bearing deposits are down 25% YOY and the bank has shed $1 billion in short-term debt. In many ways, this profile illustrates how the runoff of reserves at the Fed will slowly force all banks to shrink their balance sheets.

Our worry regarding TCBI is that one-third of the bank’s book is mortgage finance and that sector is going to undergo a fairly radical consolidation over the next 18 months. We barely did $2 trillion in new loans in 2022 and we could remain at this level of production for several years to come. That means that half of today's capacity needs to leave mortgage finance. Lenders are losing a couple points on every loan they close, meaning that many independent bankers will be closing their doors if they have any market sense.

Back in March, we wrote in National Mortgage News about the bankruptcy of Reverse Mortgage Funding (RMF). The documents filed with the Bankruptcy Court suggest that TCBI took a $40 million loss on advance lines for Home Equity Conversion Mortgage (HECM) participations (aka “tails”). As yet, TCBI has not reported the loss to investors.

So the bottom line seems to be that TCBI is not going to tell investors about the $40 million loss the bank incurred when the US Treasury took possession of the reverse servicing book of RMF. When we asked TCBI yesterday about the RMF bankruptcy, they replied: “We do not provide comments on either clients or ongoing bankruptcy proceedings.” Got it. We look forward to your timely disclosure.

Since the RMF MSR has been sold, we assume that ends any possibility of the Treasury reimbursing TCBI. The financing for the HECM tails were repudiated by the US government, seemingly with finality, because only the first financing of a HECM loan into a Ginnie Mae MBS includes the mortgage note. The subsequent advances are participations, which are easily repudiated by a sovereign. Of interest, after incurring over $1.5 billion in losses on the RMF book, Ginnie Mae finally sold the festering HECM MSR to Longbridge for $1.

TCBI’s efficiency ratio was 65% in Q2, the best level in some quarters, vs 59% for Peer Group 1. We think that the bank is going to need to cut expenses in a pretty serious fashion over the rest of 2023, figure 10%. In terms of overhead, TCBI was in the 72nd percentile of Peer Group 1 with 2.6% overhead vs total assets compared with 2.3% for Peer Group 1.

TCBI needs to keep efficiency in the 50s if they want to survive the coming drought in mortgage lending. Only banks at or below peer levels of operating efficiency have a chance to grow shareholder value, one reason why we beat up Bank of America (BAC) CEO Brian Moynihan. The efficiency ratios for the top banks in Q1 are shown below. In Q2, JPM was at 49. As one of our friends in the world of finance who came from big time collegiate sports likes to say: "Get in the game."

Source: FFIEC

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